Document Number
03-65
Tax Type
Corporation Income Tax
Description
Foreign source income, apportionment factor adjustments
Topic
Accounting Periods and Methods
Allocation and Apportionment
Computation of Income
Royalties
Taxability of Persons and Transactions
Date Issued
08-19-2003
August 19, 2003


Re: § 58.1-1821 Application: Corporate Income Taxation

Dear *****:

This will reply to your letter in which you contest the assessment of corporate income tax and interest against your client, ***** (the "Taxpayer') and its affiliates for the taxable years ended January 28, 1996, February 2, 1997, and December 31, 1997. I apologize for the delay in response.
FACTS

For the taxable years at issue the Taxpayer and its affiliates filed a consolidated Virginia income tax return. Under audit, the Department made a number of adjustments. The Taxpayer is contesting the disallowance of the foreign source income subtractions and adjustments made to the apportionment factors.
                    • DETERMINATION

Foreign Source Income

The provision permitting the subtraction for foreign source income is Va. Code § 58.1-402(C), which states:
    • There shall be subtracted to the extent included in and not otherwise subtracted from federal taxable income ....
    • 8. Any amount included therein which is foreign source income as defined in §. 58.1-302.
  • Virginia Code § 58.1-302 defines foreign source income as:
  • 1. Interest, other than interest derived from sources within the United States;
  • 2. Dividends, other than dividends derived from sources within the United States;
  • 3. Rents, royalties, license, and technical fees from property located or services performed without the United States or from any interest in such property, including rents, royalties, or fees for the use of or the privilege of using without the United States any patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like properties;
  • 4. Gains, profits, or other income from the sale of intangible or real property located without the United States; and
  • 5. The amount of an individual's share of net income attributable to a foreign source qualified business unit of an S corporation.

The Taxpayer has contested a number of adjustments to its foreign source income subtraction. Each item of foreign source income as it would be subject to the foreign source income subtraction and expenses related to the foreign source income subtraction are addressed below.

Foreign Source Royalty Income

Under audit, the Department determined that the royalties reported as foreign source income by the Taxpayer were part of the selling price of tickets sold for the Taxpayer's performances outside the United States. Based on this analysis, the auditor removed the royalties from the foreign source income subtraction. The Taxpayer contends that royalty payments were received from foreign promoters.

The Taxpayer contracted with promoters in foreign countries to assist in putting on performances of the Taxpayer's shows. Among the services the promoters provided were choosing and acquiring venues, providing all necessary event personnel, providing transportation and lodging for the performers, arranging for promotion and advertising, and providing ticket sales. In order to use copyrighted characters and stories in the performances, the promoter remitted royalty payments to the Taxpayer. Royalties earned without the United States are eligible for the foreign source income subtraction. As such, the royalty income received from the foreign promoters will be included in the Taxpayer's foreign source income computation.

Foreign Source Advertising and Promotion Services

The auditor removed sponsorship income from the foreign source income subtraction. You contend that sponsorship income is intangible property because it represents a "right" that is sold to entities that want to be associated with the Taxpayer's tours. As such, the sale of this right represents intangible property subject to the foreign source income subtraction. The relevant issue is whether the sponsorship is intangible property or whether it constitutes advertising services provided by the Taxpayer on behalf of the Sponsor.

For a flat fee, the Taxpayer sells the right to become the sponsor of a particular tour of shows. In exchange for this fee, the sponsor is provided with the opportunity to advertise at the performances. For example, the sponsor would be allowed to place a banner in the performance space and to place an advertisement in the souvenir program. The Taxpayer will perform certain services on behalf of the sponsor such as hanging the banners and incorporating the sponsor's logo in advertising artwork.

A foreign source income subtraction is allowed for gains, profits, or other income from the sale of intangible or real property located without the United States. The Department has previously ruled that the words "technical fees from ... services performed" cannot be taken out of their context to create a subtraction for income earned from the performance of services outside the United States for any service which can be characterized as of a technical nature. See Public Document ("P.D.") 86-209 (11/3/86) and P.D. 92-44 (4/27/92). In order to qualify for the Virginia FSI subtraction, "technical fees" must be incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. See P.D. 91-57 (3/29/91) and P.D. 96-381 (12/20/96).

The Taxpayer provides a forum for the tour sponsor to advertise its products or services. The Taxpayer places the sponsor's banners in the arena and incorporates the sponsor's logo in advertising artwork. Such services constitute advertising ineligible for the foreign source income subtraction.

Foreign Source Concession Income

The auditor removed concession income from the foreign source income subtraction. You contend that concession income represents a fee charged to a concessionaire for the right to sell concession items at events sponsored by the Taxpayer. This right is intangible property and the sales of such rights without the United States would be eligible for the foreign source income subtraction.

A review of a concession agreement indicates that the Taxpayer and a foreign corporation ("Corporation A") entered into a joint venture agreement to sell concession items. This agreement describes the intensive commitment and involvement of the Taxpayer and Corporation A in the sale of the concession items. The Taxpayer provided the merchandise for the concession sales. The Taxpayer and Corporation A each provided an equal number of individuals to work the concession operations. Corporation A paid the Taxpayer a flat fee and split the concession proceeds equally with the Taxpayer.

Based on the facts presented, the Department concludes that the concession income represents income from the sale of merchandise, not the sale of an intangible right. As such, the concession income is not eligible for the foreign source income subtraction.

Foreign Source Interest Income

The Taxpayer states that it erroneously failed to subtract interest income earned without the United States for the taxable year ended February 2, 1997. A review of the foreign source income subtraction schedules that were provided by the Taxpayer indicates that the Taxpayer had included the interest in calculating its foreign source income subtraction. This interest was included as part of the foreign source income subtraction as adjusted by the auditor. As such, this interest income has been included in the foreign source income computation.

Related Expenses to Foreign Source Income

In determining expenses related to foreign source income, the Taxpayer allocates certain overhead costs to various types of foreign source income. It has been the Department's long-standing policy that the computation of the Virginia foreign source income subtraction (considering expenses related to the income) be determined in accordance with Internal Revenue Code ("IRC") § 861 through § 863. See P.D. 86-154 (8/14/86). Virginia law requires the use of the federal sourcing rules of IRC § 861 et seq., whether or not a taxpayer believes that certain expenses have any connection to income from foreign sources and regardless of what expenses would be under generally accepted accounting principles.

The provisions of IRC § 861 et. seq. contain elaborate detail on assigning income and deductions to particular sources. The provisions differentiate between deductions that are definitely allocable and expenses, which are not definitely allocable. First, definitely allocable deductions that are directly related to a class of income are allocated and then apportioned between foreign and domestic source income. If a deduction is not definitely related to any gross income, the deduction must be apportioned ratably between each class of foreign and domestic source income.

The purpose of Form 1118 is to compute the limitation on the amount of foreign taxes that can be claimed as a credit against federal tax liability. When the procedures of the IRC § 861 et seq. are used to complete Form 1118, the information reported on this form is considered useful and presumed correct and accurate.

A review of the Taxpayer's Form 1118 for the taxable years at issue reveals that the other definitely allocable deductions and an apportioned share not definitely related expenses exceed the eligible foreign source income. In addition, the amounts recorded on the Taxpayer's Form 1118 do not reconcile with the schedules provided for the Taxpayer's foreign source income subtraction calculation. As such, the Taxpayer does not appear to be eligible for a foreign source income subtraction for the taxable year ended January 28, 1996, and February 2, 1997.

For the taxable year ended December 31, 1997, the Taxpayer did not claim a federal foreign tax credit and, therefore, there was no Form 1118 filed for that year. The lack of a Form 1118 does not disqualify a taxpayer from claiming the Virginia foreign source income subtraction. However, a taxpayer must provide sufficient information to the Department in order to determine the accuracy of any subtraction claimed. See P.D. 96-363 (12/9/96).

The methodology used to determine the foreign source income subtraction for the taxable year ended December 31, 1997, is similar to that used for the taxable years ended January 28, 1996, and February 2, 1997. Because of the deficiencies found with the information provided for the preceding taxable years, the Department cannot rely on the schedules provided for the taxable year ended December 31, 1997. As such, no foreign source income subtraction will be allowed for that year.

Property Factor Adjustments

Virginia Code § 58.1-409 provides:
    • The property factor is a fraction, the numerator of which is the average value of the corporation's real and tangible personal property owned and used or rented and used in the Commonwealth during the taxable year and the denominator of which is the average value of all the corporation's real and tangible personal property owned and used or rented and used during the taxable year and located everywhere, to the extent that such property is used to produce Virginia taxable income and is effectively connected with the conduct of a trade or business within the United States and income therefrom is includable in federal taxable income.

The Taxpayer made numerous assertions involving the property factors for the taxable years at issue. These assertions are addressed below.

Inventory

Title 23 of the Virginia Administrative Code ("VAC") 10-120-160 provides that inventory in which the corporation has the right of use or possession is included in the property factor. The Taxpayer contends that inventory was incorrectly excluded from both the property factor numerator and denominator for the taxable years ended January 28, 1996, and February 2, 1997. The Taxpayer has provided documentation to show the correct amounts of inventory that should be in the property factor. The audit will be adjusted accordingly.

Partnership Property and Rent

In general, the property of a partnership will be included in the numerator and denominator of the corporation's apportionment formula in proportion to the corporation's ownership interest in the partnership. See P.D. 88-226 (7/29/88) and P.D. 95-19 (2/13/95). The Taxpayer contends that partnership rent expense was excluded from the property factor denominator for both taxable years ended January 28, 1996, and February 2, 1997, and that an affiliate's partnership property was excluded from the property factor denominator for the taxable year ended January 28, 1996. The Taxpayer has provided no documentation to verify the rent expense from the partnership or the affiliate's partnership property. As such, the rent expense and the affiliate's property were properly excluded from the Taxpayer's property factor.

Intercompany Rent

Virginia relies on the amount and character of each receipt included on the federal return and supporting schedules to determine gross receipts in the computation after the elimination of intercompany items as provided in 23 VAC 10-120-322. The Department has previously ruled that receipts are to be included in the computation of the sales factor only to the extent they are included in a consolidated return. Accordingly, intercompany transactions that should be eliminated in determining consolidated income would not be included in the computation of the consolidated sales factor. See P.D. 01-194 (12/3/01).

In this case, the intercompany transactions consisted of rent for tangible and real property. The Taxpayer contends that the intercompany rents paid among the Taxpayer and affiliates were incorrectly included in the property factor numerator for both taxable years at issue. Because the intercompany rent transactions were eliminated in determining the consolidated taxable income of the Taxpayer and its affiliates, the intercompany rent should be excluded from the property factor numerator. The property factor will be adjusted accordingly.

Building rent

Pursuant to 23 VAC 10-120-170, property that is owned is valued at its original cost and leased property is valued at eight times the net annual rental rate for purposes of the property factor. The Taxpayer contends that a leased building was incorrectly treated as both leased and owned in the property numerator and denominator for the taxable year ended February 2, 1997.

According to the Taxpayer, the lease of the building was reported as a capital lease and included as an asset for financial accounting purposes, but the lease is treated as an operating lease for income tax purposes. As such, the rent payments made on the building would be included in capitalized rents in the property factor. The Taxpayer has, however, not provided sufficient evidence to demonstrate that the leased building was included in both owned property and capitalized rents. As such, the auditor's adjustments are upheld.

Sales Factor

Virginia Code § 58.1-414 provides:
    • The sales factor is a fraction, the numerator of which is the total sales of the corporation in the Commonwealth during the taxable year, and the denominator of which is the total sales of the corporation everywhere during the taxable year, to the extent that such sales are used to produce Virginia taxable income and are effectively connected with the conduct of a trade or business within the United States and income therefrom is includable in federal taxable income.

Virginia. Code § 58.1-302 defines the term "sales" as the gross receipts of the corporation from all sources (except dividends, which are allocated), whether or not such gross receipts are generally considered sales. The sales factor includes all gross receipts that are included in Virginia taxable income and are connected with the conduct of the taxpayer's trade or business within the United States.

Foreign Source Receipts

The auditor adjusted the sales factor to include the gross receipts of foreign source income when it was determined the related expenses exceeded foreign source income. In contesting the adjustments to the foreign source income subtraction, the Taxpayer has asserted that these receipts should be excluded from its sales factor.

A corporation claiming a subtraction for foreign source income will adjust its apportionment factors in accordance with 23 VAC 10-120-150 (B)(2)(b). This regulation provides in pertinent part:
    • The property, payroll and sales of a corporation which are used to produce income qualifying for the subtraction for . . . foreign source income shall not be included in the denominator of the fractions.
    • Title 23 VAC 10-120-20 further provides:
    • All income and expenses included in foreign source income and property or other activity associated with such income and expenses shall be excluded from the factors in the Virginia formula for allocating and apportioning Virginia taxable income to sources within and without Virginia.

Pursuant to these regulations, foreign source income that qualifies for the Virginia subtraction will be excluded from the denominator of the sales factor. Because the Department finds that the Taxpayer was not eligible for foreign source income subtraction, the adjustment made by the auditor to include the Taxpayer's foreign receipts in the sales factor is correct.

Sales from a Partnership

In general, the sales of a partnership will generally be included in the numerator and denominator of the corporation's apportionment formula in proportion to the corporation's ownership interest in the partnership. See P.D. 92-57 (4/29/92) and P.D. 95-19 (2/13/95).

The Taxpayer contends that a portion of the Taxpayer's share of general partnership revenue from the sales factor was incorrectly reported in the sales factor denominator for the taxable years ended January 28, 1996, and February 2, 1997. The Taxpayer also contends that an incorrect amount of general partnership income was reported in the sales numerator. The Taxpayer has failed to provide adequate documentation to demonstrate that the auditor's adjustments to the numerator and denominator of the sales factors were incorrect.

Intercompany Sales

Virginia relies on the amount and character of each receipt included on the federal return and supporting schedules to determine gross receipts in the computation after the elimination of intercompany items as provided in 23 VAC 10-120-322. Consequently, such receipts would be included in the computation of the sales factor only to the extent they are included in a consolidated return. Accordingly, intercompany receipts eliminated in determining consolidated income would not be included in the computation of the consolidated sales factor. See P.D. 01-194 (12/3/01).

The Taxpayer contends that intercompany sales revenue was incorrectly included in the sales factor numerator and that an affiliate's revenue was incorrectly included in the sales factor denominator. The intercompany sales appear to be from partnerships but the Taxpayer has provided insufficient evidence to exclude the revenues from these transactions as intercompany sales.

Capital Gains

The Taxpayer contends that a capital gain was incorrectly included in both the sales factor numerator and denominator for the taxable year ended February 2, 1997. A review of the Taxpayer's federal Schedule D from its federal income tax return for the taxable year ended February 2, 1997, indicates that the capital gain was properly included by the auditor in the sales factor numerator and denominator. No documentation was presented by the Taxpayer to refute the auditor's adjustment.

Math Error

The Taxpayer has asserted that the auditor erroneously included the incorrect amount of interest and royalty income from one of its affiliates in the numerator of the sales factor for the taxable year ended January 28, 1996. A review of the documentation provided indicates that the Taxpayer is correct and the audit report has been adjusted accordingly.

Summary

The Department requested additional information to substantiate your claims concerning the contested audit adjustments. Inasmuch as the Taxpayer has not furnished substantive documentation with regard to the expenses related to foreign source income and several of the apportionment factor adjustments, this determination has been based on the best available information.

In any proceeding relating to the interpretation of the tax laws of the Commonwealth of Virginia, the burden of proof is on the taxpayer. As such, the Taxpayer must prove by clear and cogent evidence that the adjustments made by the auditor to the foreign source income subtraction and apportionment factor for the taxable years ended January 28, 1996, February 2, 1997, and December 31, 1997, are not correct.

The audit assessments have been adjusted in accordance with this determination on the attached schedules. The Department will, however, review any additional information you can provide which substantiates your claim, providing we receive it within-30 days of the date of this letter. Please send this additional information to *****, Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 1880, Richmond, Virginia 23218-1880. If we receive no response within 30 days, this case will be considered closed.

Copies of the Code of Virginia, regulations and public documents cited are included for reference purposes. These and other reference documents are also available on-line in the Tax Policy Library section of the Department's web site, located at www.tax.state.va.us. If you have any questions, you may contact .
                    • Sincerely,

                • Kenneth W. Thorson
                  Tax Commissioner



AR/29688B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46